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Explain with examples the multiplier effect using the AE-Y diagram (Keynesian cross diagram/ Keynesian 45 degree line diagram). [10]


Introduction to the Keynesian Multiplier Effect

What is the multiplier effect? The multiplier effect can be defined as the total change in income for a given change in injection. The formula for calculating the multiplier, k, is 1/ (1-MPC), where k refers to the multiplier, while MPC refers to the marginal propensity to consume out of national income on domestically produced goods. Alternatively, the multiplier can also be defined as 1/ MPW, where MPW is the marginal propensity to withdraw.

However, because not all of income is spent on domestically produced output, therefore, 1 - MPC =  MPS + MPT + MPM, where MPS, MPT, MPM refer to the marginal propensities to save, tax and import, respectively. Therefore, MPS + MPT + MPM = MPW, the marginal propensity to withdraw. Hence, more importantly, the final multiplier formula discussed in this Economics paper would be k = 1/MPW.

The Keynesian Cross Diagram (AE-Y)

(THINKING QUESTION: How would you draw the AE-Y diagram, and how would it look like? Do please be sure that you can draw and illustrate the various Economics diagrams properly. Perhaps you can try crafting the diagram under timed or simulated examination conditions.) 

In the AE function graph, Aggregate Expenditure is drawn against nominal National Income. 

Aggregate Expenditure refers to the total planned expenditure on domestic output for a given level of national income, whereas nominal national income (Y) refers to the total nominal income or total nominal value of output generated by the economy.

In the AE-Y graph, as the national income rises, the AE also rises. This is due to an increase in national income which leads to similarly an increase in personal income, therefore household consumption increases with a greater amount of money to spend. When consumption increases, induced expenditure also increases, where induced expenditure means that spending is income-dependent. 

It should be noted that the gradient of the graph is determined by the MPC. A higher MPC means that the graph would be steeper. However, households do not spend all their income on consumption on domestically produced goods. They also have to pay income tax, reducing their disposable income. Within their disposable income, a portion is saved and another is spent on imported goods. Therefore MPC < 1 where MPC = 1 - MPW. This explains why the AE curve is less steep than the Y=AE line.

(A numerical illustration could shed some light on the question.) The multiplier effect can be calculated using such a method. Suppose that the government spends $100 and assuming that the MPC = 0.8, induced consumption would rise by $80 (0.8x100). This would boost AE and cause consumption to rise again by $80, where (0.8x80)=$64 would be spent on consumption. After repeated rounds, the total income would increase by $500 (80+64+..). Therefore the multiplier effect is calculated by 500/100 (the original injection)= 5.

Insert AE-Y Diagram/Model with Corresponding Economics Explanation - Think: How Would It Look Like?

The size of the multiplier effect affects the usefulness of expansionary fiscal policy. Expansionary fiscal policy refers to the increase in government spending and/or a reduction in direct taxes, to achieve demand management at the macroeconomic level. With a large multiplier, the impact of expansionary fiscal policy would be greater. This is because a large multiplier would mean that nominal national income increases by a greater factor relative to the size of the injection. 

Comment on Singapore's Economy - Her Small Multiplier, k

However, it has to be said that in the case of Singapore, Singapore has a small multiplier due to our MPW being high. After all, Singapore is import dependent due to her lack of natural resources and has relatively high savings due to compulsory savings schemes such as CPF (Central Provident Fund), and thus has relatively high MPM and MPS, thus resulting in a high MPW. Therefore, the multiplier effect on Singapore would be limited to a very large extent. 

JC Economics Essays: (H2, H3 A Levels) Economics Tutor's Comments - This is a very short, sharp, and accurate Economics paper that addresses the requirements of the question posed directly. The Economics topic here is on the multiplier effect and the AE-Y diagram/ model. This is the basis of Keynesian economics. Students can learn a lot from this essay style of direct writing. However, the usual tutor's question applies: how can I make this Economics essay better? What can I learn from it, and what would I have written that the author missed? Or what has the author written here that I have not addressed? Special thanks to A. C. who contributed this Economics article (write up). Thank you for reading, and cheers. 

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